Big things are happening with private market liquidity. Just as the tokenization fad crashed and burned, a much bigger wave of PE secondary transactions took off on a hockey stick growth path.
The successful efforts have the right attributes for their level of exchange. They fit themselves into good slots on a liquidity ladder.
Assets are moving up and down the ladder
This ladder becomes more interesting when you realize that issuers and investors have incentives to move between categories. In the past ten years more than 4 trillion dollars of assets have moved from public to private categories. Now they are starting to move around in the private categories.
Issuers have incentives to migrate toward greater liquidity. This gives them access to a large pool of investors. It also gives them a “liquidity premium”. Investors might pay more for their securities, and give them a higher valuation, if they can easily resell the securities. The resale market reduces their risk, allows them to manage their need for money over time, and gives them options for future re-investment. Academic studies have put this liquidity premium at about 25%.
However, there is obviously a lot of motivation for issuers to move away from public liquidity to private illiquidity.
- A smaller number of shareholders might pay a premium for control
- They can lock investors into a long term commitment, and create incentives for them to add value
- They have more confidentiality and less disclosure cost
- They avoid NEGATIVE liquidity premiums. Large-cap, actively traded securities will usually be worth more if they can trade. But, small cap stocks may be worth less if they trade. They have few bidders, and when someone goes to sell, there may not be bidders to buy the order. Smaller companies have been leaving the US public markets since 1996. There is a theory that this happened because of changes in the rules for marketmakers, which made it unprofitable to buy and redistribute sell orders in small issues. The minimum float size to benefit from trading in public stocks may be over $200M.
Investors put a lot of money into public securities. They like to carry private securities into traded markets, where they can get resale options and a liquidity premium. Even inside the public markets, they tend to prefer the more liquid securities. This has been a good investment strategy during the last ten years, when money from quantitative easing has driven big returns in big passive stock indexes.
However, private buyout funds have even bigger returns. Investors may want to follow issues into the private market for a number of reasons:
- Returns may be higher. Theoretically, there is an illiquidity discount that enhances returns.
- They want to convert time into money. They may be very patient investors, and they can seek higher returns by offering to lock up money for long periods.
- There are new assets and new asset classes being created, and they have a hypothesis that some of these asset classes are a good bet. There are also increased returns from doing smaller and more obscure deals.
- They have specialized knowledge, and time for hands-on management and value add
Navigating the middle of the ladder
We have huge markets for the top of the ladder (very long term investments) and the bottom of the ladder (fully public actively traded investments). A lot of the current interest in private market liquidity is an attempt to fit more securities into the middle slots on the ladder. It’s an attempt to have the best of both worlds- the returns from a long term commitment, and a relationship with heavy-hitting investors, with options for resale.
I’ll go out on a limb here. In my observation, this doesn’t work well when issuers try to do it. They end up pushing a long-term investment into a slot that does not fit the limited size and disclosure of their security.
It is working when investors do it. They do quality control, they get benefits from locking up money for a long time in private investments, and then later they find a way to resell the investments. This is how VC’s are supposed to make money, by taking companies to IPO. However, the IPO channel has become less attractive, so investors are selling into the middle slots, starting with PE secondaries. According to Triago, they exchanged $60B worth of PE secondaries in 2018, and $90B in 2019, with a continuing upward trajectory.
So, what happens when funds do it? In theory, we should be able to package long term “alternative” investment funds for resale as liquid securities.
This works in real estate. Facts show that public REITs often are better investments than private real estate partnerships. However, in other categories of PE and VC, the public options are limited, and small private funds often outperform. United States regulations make it especially difficult to trade these funds. And, the existing LP deals are optimized in a way that makes the securitized version unattractive. I have written about securitized funds, and I continue to work on new structures that will make this possible, such as Unbundled Funds. Hopefully we will have more conclusive solutions soon.
Tips and tricks
You get liquidity when there are multiple bidders for your asset.
You will get multiple bidders if you have a large number of existing shareholders, and they have a flow of information that makes them confident in valuing your asset, from disclosure, ongoing reporting, or observable features such as network activity.
What works in private offerings
The private end of the ladder is great for building value with long-term commitments. Private offers have some attributes that we need to keep in mind:
- If the offer requires a lot of research and due diligence on the investor side, then an issuer should only offer it to a small group of investors. Investors are not going to invest time in a deal they are likely to lose to other bidders.
- The terms are often customized. The terms have to fit the investor because investors are making a long-term commitment, and they won’t easily be able to get out if the investment doesn’t fit their expectations. Investors can ask for customization in return for their commitment to due diligence.
- Issuers can ask for confidentiality
- Investors will often get information on-demand, rather than scheduled disclosures
- Offerings can be any size from very small to large.
What works in public offerings
The public end of the ladder can have better pricing and higher volume because it reduces the risk that investors take when they lock up money for a long time. Public offers also have some natural attributes:
- The offers are not customized. They are standardized as much as possible, and packaged into a few large-cap tranches. If an investor does not like the terms, they can sell.
- They have good disclosure about the security and the underlying business.
- They have a large float and a lot of shareholders
Problem: Crowdfunding and “democratization” are failed concepts for small investments
It sounds good to offer professional investment opportunities to a wider audience that invests smaller amounts. This is the promise of crowdfunding and “democratization”. Hundreds of products have been launched with that goal. However, they don’t work! Here are some reasons that investors avoid them:
- Adverse selection. These offers tend to be bad investments. Issuers will not go through the time and expense of selling an investment to many small investors, if they have a good deal that a few large investors will buy.
- It’s hard to get money back. There are no bidders for issues that tend to be small with poor disclosure.
- Small market. There is not much money available from individual investors who do research to select individual small cap investments. Dentists from Germany are not going to be analyzing strip mall properties in Florida (as described in an actual proposal that I received). It is not a good use of their time, and they realize that professional investors have better information. Individual investors place most of their money with professionally managed funds, either directly, or through pensions.
If we want to provide all investors with access to a full range of investments, we would drive down the cost of fund management, and expand the range of publicly available, large-cap investment structures to more easily include “alternative” investments.
If you are buying, selling, or building new financial services, it’s important to work in coherent slots in the liquidity ladder. I have been working on digital private markets and Unbundled Funds. This ladder is adapted from some of of our strategic guidelines.